LIVE MARKETS-Is the Fed too stringent with its 2% inflation target?

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IS THE FED TOO STRINGENT WITH ITS 2% INFLATION TARGET?

The Federal Reserve may be being too rigid on how it calculates getting inflation back to its 2% annual target and could be underestimating the likelihood that inflation will drop more than expected, according to Societe Generale analyst Albert Edwards.

Fed officials have expressed concern that inflation will remain higher for longer, which would make further interest rate cuts less likely. The prospect of tariffs by the Trump administration has added to inflation fears.

But Edwards notes that several factors, including a strong U.S. dollar, may point to lower inflation. “The dollar plays a major role in the ups and downs of import prices and the recent dollar surge is set to send import prices sharply lower,” he said. Excess capacity in China is adding to drops in import prices.

Meanwhile concerns about entrenched supercore services inflation are likely overdone, with labor costs back close to 2% year on year. Shelter inflation, which has kept the core consumer price index stubbornly high, is also set to accelerate its decline.

Edwards further argues that the Fed should not be focused on core CPI at 3.2%, but instead the core PCE deflator, which is rising annually at 2.8%. And market based measures of this core PCE deflator are even lower at 2.4%.

Former Fed Chair Paul Volcker “excoriated the Fed” in Oct. 2018, when he argued that the 2% annual target must have some degree of latitude on either side due to measurement errors, and that from 2010 to 2020 “the Fed’s obsession to drive it back up to 2% caused it to pursue an excessively loose monetary policy.”

“Volcker’s criticism equally applies now, but in the opposite direction,” Edwards said. The Fed should be focusing on the core PCE deflator, and not core CPI. Meanwhile, “measurement errors mean that a stable core PCE between 2-3% is just fine and consistent with price stability.”

Thus, Edwards warns that deflationary forces could overwhelm any inflationary impact from tariffs and surprise market participants.

(Karen Brettell)

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